Big Banks Bad, Small Banks Worse

Felix Salmon has this to say:

Earlier this week, Matt Yglesias wrote a post about what he calls “America’s Microbank Problem”: this country has far too many banks, he says, and they’re far too small. A rebuttal soon came from Rob Blackwell of American Banker, who called Yglesias “dead wrong”. This is an argument which clearly needs to be adjudicated! And in this case, I’m afraid, Blackwell wins.

Salmon is taking the easy option here, but Yglesias is clearly right.  I’ve been bashing small banks for years, but no one pays attention.  So I’ll have to do it again.

As for the idea that FDIC insurance makes small banks riskier — well, that’s just bizarre. The FDIC crawls all over small banks, precisely because it has so much at risk. And because small banks have simple operations which are easy to understand, the FDIC can and does step in early when they start getting into trouble. Effectively, small banks have the better of two management teams: the in-house one, or the FDIC. And the FDIC knows what it’s doing.

Nope, FDIC creates moral hazard on steriods, which is one of the reasons why we have had two major small banking fiascos in the past 35 years, once in the 1980s and once again after 2008.  Both had the same cause, small banks took advantage of FDIC-insured deposits to shovel lots of loans to developers of risky projects in sunbelt states.  Heads the banks and developer cronies win; tails the taxpayer loses.

What’s more, if the FDIC ever has any difficulty regulating these banks, all it needs to do is raise its dues to make up for the extra risk that it’s facing. Essentially, the US banking system regulates itself: the dues from profitable banks go towards rescuing troubled banks. The rest of us never need to worry. Except, of course, when the bank is so big that the FDIC can’t afford to let it go bust. It’s the too-big-to-fail banks which are the real problem, not the little ones.

Just the opposite, the big banks are a problem but the small banks are much worse.  The FDIC fees on the good banks are a tax passed on to bank customers, just as surely as a tax on gasoline or cigarettes is passed on to customers.  I pay via more costly bank services in Boston to bail out overcompensated depositors of shady banks in Georgia.  So I do “need to worry.”

Smaller banks can pose a systemic risk, as we saw in the S&L crisis.

As we saw in the S&L crisis and as we saw in the very similar 2008 crisis.  Yes, the big banks were also irresponsible in 2008, but at least they repaid their TARP loans.  The FDIC money shoveled to small banks is money down the drain, a loss to taxpayers.

We’ve had three banking crises in the past 100 years while Canada (a country without small banks) has had zero.  The political power of the small banks played a major role in causing the Great Depression, which led directly to WWII.  Small bankers who lobby Washington for special favors have blood on their hands.

Kudos to Yglesias for not taking the easy populist approach to banking.

About Scott Sumner 492 Articles

Affiliation: Bentley University

Scott Sumner has taught economics at Bentley University for the past 27 years.

He earned a BA in economics at Wisconsin and a PhD at University of Chicago.

Professor Sumner's current research topics include monetary policy targets and the Great Depression. His areas of interest are macroeconomics, monetary theory and policy, and history of economic thought.

Professor Sumner has published articles in the Journal of Political Economy, the Journal of Money, Credit and Banking, and the Bulletin of Economic Research.

Visit: TheMoneyIllusion

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